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ANALYSIS: Hedge Accounting: Is it feasible?

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“Differing accounting recognition and measurement criteria, applied to various components of a hedge relationship, create volatility in financial reporting”

Hedge accounting is becoming imperative for companies exposed to exchange rate volatility

The recent volatility in the South African rand (ZAR) has seen many local corporates scrambling to control the impact of dwindling local currency value on their financial results. The exchange rate with the USD has fluctuated widely in the past five years, from a low of R6.60 to as high as R10.60 – a movement of over 60%. This volatility is not new, but has been more pronounced over the past year.

ZAR/USD exchange rates

The South African economy, as a net importer, is highly impacted by these changes. As the rand devalues, the cost of importing foreign goods in local currency climbs, creating additional inflationary pressures. Furthermore, for larger corporates and state-owned companies that have foreign funding, servicing these liabilities becomes more expensive. The financial markets are the only mechanism of protection for the corporates from the onslaught. They are forced to transact in derivative contracts to provide some protection, or at least more certainty in their future cash flows. While derivatives offer an economic hedge, the challenge of managing the impact of foreign exchange volatility is not yet complete.

Differing accounting recognition and measurement criteria, applied to various components of a hedge relationship, create volatility in financial reporting. These differences primarily relate to the timing of the valuation of these components. For accounting purposes the underlying exposures are not recognised, or only recognised on a conventional accrual basis. The derivatives are fair-valued regularly and therefore immediately reflect the full impact of market movements. Although these timing differences will eliminate over the lifetime of the hedge, mismatches will be recorded at various financial reporting periods. As a result many organisations will not actually display the result of economic hedge transactions in their financial results. Worse still, this accounting mismatch results in financial earnings volatility.

The only accounting mechanism to control this mismatch is to apply hedge accounting.  Hedge accounting has, however, been avoided by many corporates as a result of the rules based approach laid out in IAS 39 Financial Instruments: Recognition and Measurement. It has often been perceived by corporates as onerous, inflexible and costly to implement. The standard setters have responded to these concerns with a recent review draft for general hedge accounting (see below for more information), included under the IFRS 9 Financial Instruments project and a forthcoming discussion paper on macro hedging. Unfortunately, the standard setters have tentatively decided to defer the implementation date to beyond 1 January 2015. With the existing exchange rate volatility, can corporate South Africa afford to wait for these changes?

Are corporates caught between opposing forces? On one side there is a growing need to hedge foreign exchange volatility and on the other the application of hedge accounting, a technical accounting requirement.

Are the hedge accounting requirements that onerous?

The requirements laid out in IAS 39 to apply hedge accounting are by no means insurmountable. In essence these are the steps that management would or should be considering when entering into foreign exchange hedging programmes. The requirements to apply hedge accounting are, in essence, a handful of steps:

  • Identify the hedge exposure and the instrument entered into to address this exposure.
  • Expect the hedge transaction to be highly effective (within 80–125%) and demonstrate this effectiveness in historical results and future outlook.
  • Document all of this prior to implementing the proposed hedge.

These steps, at face value, do not appear as burdensome as some may suggest. Where many corporates do struggle is with the documentation requirement. In many cases this is seen as an afterthought and occasionally is not formalised to the required standard. Considering the onslaught of exchange rate volatility, surely the administrative burden of documentation shouldn’t be seen as an impediment.

No alternative to hedge accounting

It looks like exchange rate volatility is a reality for South African business. Successful operations will be distinguished by being able to manage the impact of this environment as effectively as possible. The application of hedge accounting has to be a primary consideration for organisations needing to accurately capture in their financial results the effects of exchange rate volatility. Hedge accounting will have cost implications and could require a re-think of the reporting structures and processes to adequately meet the requirements.

To put it bluntly, as a local treasurer recently did: “If our organisation doesn’t hedge-account, it may as well not economically hedge and if we do not hedge ourselves in the market, with the current volatility, we may as well stop operating.”

Impact of the review draft on general hedge accounting

The International Accounting Standards Board (IASB) is changing the requirements for hedge accounting to be principles-based and aligned with an entity’s risk management practices. This is to help make financial statements more meaningful.

The near-final hedge accounting amendments to general hedging (expected to be finalised during November 2013) will have the following implications:

  • New requirements to achieve hedge accounting focus on the economic relationship between the hedged item and hedging instrument, the effect of credit risk and the hedge ratio. The 80–125% bright line has been removed. Judgement is needed in assessing prospective hedge effectiveness (no retrospective testing).
  • Certain executory contracts to buy or sell non-financial items, for example commodities (‘own-use contracts’) may be measured at fair value if they are economically hedged with derivatives. This is a simpler alternative to hedge accounting and eliminates the accounting mismatch. (The IASB is further considering the designation of existing own-use contracts at the date of initial application.)
  • Certain credit exposures (such as loan portfolios and commitments) may be measured at fair value if credit derivatives are used to manage all or part of the exposure. This alternative eliminates the challenges of separating fair value changes attributable to credit risk for hedge accounting.
  • Non-derivative financial instruments measured at fair value may be designated hedging instruments of any risk, not just forex risk.
  • The time value element of a purchased option or the forward element of a forward contract may be deferred or amortised. (The IASB is further considering expanding the requirement regarding the forward element of a forward contract to cover forex basis spreads as a cost of hedging.)
  • Additional exposures may be designated as hedged items, making hedge accounting more feasible:
    • Risk components of non-financial items and non-contractually specified inflation
    • Layer components (for example the last 20 million of principal of a debt instrument)
    • Net positions, and
    • Aggregated exposures (combination of non-derivative and derivative items)
  • Entities may need to adjust the hedge relationship if circumstances change to avoid discontinuing hedge accounting. Voluntary discontinuation of qualifying hedges is prohibited.
  • New disclosure requirements aim to achieve transparency and compensate for increased judgement.

The proposals would apply prospectively (limited retrospective application exceptions). If adopted early, all existing IFRS 9 requirements will apply. However, because of the close interaction between the general hedge accounting model and macro hedging, the IASB is also considering permitting a one-time election to defer adoption of the general hedging model until the standard resulting from the macro hedging project is effective.

Author: Gavin de Lange CA(SA) is  Partner/Director: Financial Services and Angie Ah Kun CA(SA) is Senior Manager,  Department of Professional Practice: Technical Accounting at KPMG Services (Pty) Ltd.

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